Financial Stability Paper No 28: Taking uncertainty seriously - simplicity versus complexity in financial regulation

David Aikman (), Mirta Galesic, Gerd Gigerenzer, Sujit Kapadia, Konstantinos Katsikopoulos, Amit Kothiyal, Emma Murphy and Tobias Neumann
Additional contact information
Mirta Galesic: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Gerd Gigerenzer: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Konstantinos Katsikopoulos: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Amit Kothiyal: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Emma Murphy: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH
Tobias Neumann: Bank of England, Postal: Publications Group Bank of England Threadneedle Street London EC2R 8AH

No 28, Bank of England Financial Stability Papers from Bank of England

Abstract: Distinguishing between risk and uncertainty, this paper draws on the psychological literature on heuristics to consider whether and when simpler approaches may outperform more complex methods for modelling and regulating the financial system. We find that: (i) simple methods can sometimes dominate more complex modelling approaches for calculating banks’ capital requirements, especially if limited data are available for estimating models or the underlying risks are characterised by fat-tailed distributions; (ii) simple indicators often outperformed more complex metrics in predicting individual bank failure during the global financial crisis; and (iii) when combining information from different indicators to predict bank failure, ‘fast-and-frugal’ decision trees can perform comparably to standard, but more information-intensive, regression techniques, while being simpler and easier to communicate.

Keywords: financial regulation; uncertainty (search for similar items in EconPapers)
JEL-codes: G28 (search for similar items in EconPapers)
Pages: 26 pages
Date: 2014-05-02
New Economics Papers: this item is included in nep-rmg
Note: http://www.bankofengland.co.uk/financialstability/Pages/fpc/fspapers/fs_paper28.aspx
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Citations: View citations in EconPapers (57)

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